Cushion Your Retirement by Investing in IRAs

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If I were to recommend a stock and guarantee a return of 10% to 28% on your investment in a single day, you'd no doubt line up at your broker's door to place your orders.

But then why do so many people fail to make the maximum contribution to their Individual Retirement Accounts (IRAs)? After all, in its traditional version, an IRA offers exactly the same return, depending on your personal tax bracket.

Contributions to a traditional IRA are immediately deductible from income for the tax year in which they are made.

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In other words, if you contribute the maximum of $5,000 to your traditional IRA before April 15, 2011, you can deduct the entire $5,000 from your reportable income for the 2010 tax year. That means you won't have to pay taxes on that $5,000 - which, depending on your tax bracket, is the equivalent of getting an immediate 10% to 28% return on the money.

This is perhaps the only such retroactive deduction the average taxpayer can take (outside of some more esoteric items involving depreciation, income averaging and the like).

What's more, if you're over age 50, you can contribute a maximum of $6,000 - a provision the government added to help older Americans "catch up" on their retirement savings (and, no doubt, take some of the heat off the Social Security system).

Once the contribution is made, taxes on the investment earnings they generate accumulate tax-free - greatly enhancing the compounding effect - until such time as they are withdrawn, when they will be taxed as ordinary income. (Note: The "instant return" feature doesn't apply to Roth IRAs since those contributions are made with "after-tax" dollars, allowing for later tax-free withdrawals of both principal and earnings.)

The only restriction on contributions - for both traditional and Roth IRAs - relates to income levels, which is why the "instant return" is limited to 28% rather than the 35% high-income taxpayers must shell out. For 2010, taxpayers are allowed IRA contributions based the following income limits:

Individual filers - Earnings less than $105,000, full contribution; $105,001 to $120,000, partial contribution; over $120,000, no contribution.

Married couples filing jointly - Earnings less than $167,000, full contribution; $167,001 to $177,000, partial contribution; over $177,000, no contribution. (Note: Married couples filing separately can put money in an IRA only if they earn less than $10,000.)

For future reference, the limits will increase for the 2011 tax year, as follows:

Individual filers - Earnings less than $107,000, full contribution; $107,001 to $122,000, partial contribution; over $122,000, no contribution.

Married couples filing jointly - Earnings less than $169,000, full contribution; $169,001 to $179,000, partial contribution; over $179,000, no contribution. (Note: The $10,000 limit for married couples filing separately will still apply in 2011.)

Because of those limits, taxpayers with incomes in the upper end of the 28% bracket have their IRA privileges phased out. For 2010, that bracket ranges from $82,401 to $171,850 for single taxpayers, and from $137,301 to $209,250 for married couples filing jointly.

Even with those limits, more than 80% of U.S. taxpayers are eligible to make IRA contributions - but, sadly, a remarkable number are failing to take full advantage of the IRA tax incentives.

According to a recent survey by the Employee Benefit Research Institute (EBRI), 41% of American workers are notsaving for retirement via any means - either with personal savings or through employer-sponsored retirement plans - and only 23% of those who are saving regularly max out their annual contributions.

This is a costly mistake - depriving you of both the instant return represented by the deduction, and the opportunity for your retirement savings to grow without any annual tax burden - so don't make it. Consider maxing out your IRA contribution for the 2010 tax year if you haven't already, and doing the same for 2011 so your money can get a head start on tax-deferred growth.

Here are a couple of additional points before you dig into your wallet:

  • IRAs, either traditional or Roth (which, by the way, is named after Sen. William V. Roth, Jr., R-DE, who came up with the idea as part of the Taxpayer Relief Act of 1997), can only be funded with cash or cash equivalents. Transferring any other type of asset - such as stocks, precious metals, or real estate - will cause you to lose the preferred tax treatment.
  • Once your funds are in the IRA, they can be invested in a variety of assets - including mutual funds, bonds, insurance products such as annuities, and stocks (including, in some cases, stock options) - but investments in "hard assets" are usually restricted.
  • If you don't want the expense and uncertainty of having someone else manage your retirement funds, you can establish what is known as a "self-directed IRA" in which you actively manage the money yourself (within the asset limits mentioned above).
  • You do not have to establish your IRA through your employer. Individuals can set up IRAs on their own, subject to the same restrictions applied to employer-sponsored plans.
  • If you are self-employed or run a small business, you can set up what's known as a "SEP-IRA" and have your business make the contributions on your behalf. However, if you set up a SEP-IRA for yourself, you must also make similar contributions for your employees.
  • Annual contributions can be split between traditional and Roth IRAs, so long as the total contribution does not exceed the $5,000 limit (again, $6,000 if you're over 50).
The choice between a traditional IRA and Roth IRA is yours to make, based on your expectations of current and future tax liabilities. If you think you will be in a lower tax bracket in retirement than you are now, then a traditional IRA is probably the best choice since your tax liability will be lower when the money comes out of the IRA than it is now. Conversely, if you think you'll have a higher tax burden in the future, when you begin withdrawals, then the Roth IRA may be best since you'll owe no taxes on the money - either principal or earnings - when you withdraw it.

Having said that, I personally prefer the traditional IRA for one simple reason: I don't trust Congress.

Social Security carried a promise of tax-free retirement income, as did my father's Railroad Retirement - but both are now taxed above a certain (very low) income limit. I don't believe Congress will be able to resist the temptation to tax all the money coming out of Roth IRAs.

As such, give me my traditional IRA tax deduction now, and I'll worry about future taxes later.

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